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Stagflation: Meaning and Measure to Control Stagflation

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Stagflation: Meaning and Measure to Control Stagflation!

Stagflation is a new term which has been added to economic literature in the 1970s. The word “stagflation” is the combination of stag plus flation, taking ‘stag’ from stagnation and ‘flation’ from inflation. Thus it is a paradoxical situation where the economy experiences stagnation or unemployment along-with a high rate of inflation. It is, therefore, also called inflationary recession. The level of stagflation is measured in the US by the “discomfort index” which is a combination of the unemployment rate and the inflation rate measured by the price deflator for GNP.

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One of the principal causes of stagflation has been restriction in the aggregate supply. When aggregate supply is reduced, there is a fall in output and employment and the price level rises. A reduction in aggregate supply may be due to a restriction in labour supply.

The restriction in labour supply, in turn, may be caused by a rise in money wages on account of strong unions or by a rise in the legal minimum wage rate, or by increased tax rates which reduce work-effort on the part of workers.

When wages rise, firms are forced to reduce production and employment. Consequently, there is fall in real income and consumer expenditure. Since the decline in consumption will be less than the fall in real income, there will be excess demand in the commodity market which will push up the price level.

The rise in the price level, in turn, reduces output and employment in the following three ways:

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(a) It reduces the real quantity of money, raises interest rates and brings a fall in investment expenditure,

(b) The rise in the price level reduces the real value of cash balances with the government and the private sector via the Pigou effect which reduces their consumption expenditure,

Another cause of restriction in aggregate supply is the increase in indirect taxes by central, state and local governments. When indirect taxes are increased, they raise costs and prices and reduce output and employment. Moreover, when the government increases taxes, it leads to the transfer of real purchasing power from the people to the government.

As a result, aggregate demand falls, and output and employment are adversely affected. If, however, the government increases its expenditure equal to the increase in tax revenue, it would raise the price level further due to increase in additional demand.

Often, economies impose direct controls as a means of controlling inflation. But when such controls are removed, decontrolled sectors raise prices of their products with the result that wages rise and the wage-price spiral spreads to the entire economy.

This, in turn, adversely affects production and employment through a decline in the real quantity of money, rise in interest rates, fall in investment via the Pigou effect, and exports becoming dearer and imports attractive. They contribute to stagflation.

Restriction on aggregate supply may also be caused by external factors such as rise in the world prices of food-grains and crude oil prices. In all these cases, the domestic price level is raised by outside forces. When international prices of food-grains and crude oil rise, they lead to the outflow of purchasing power away from domestic consumers.

They accentuate inflation, raise wages and prices. As a result, the real quantity of money declines, interest rates rise and investment declines via the Pigou effect, making exports dearer and imports attractive, and domestic output and employment decline. They lead to stagflation.

The phenomenon of stagflation is illustrated in Fig. 18 where employment is measured on the horizontal axis and the price level on the vertical axis. The initial equilibrium is at E where the demand curve D intersects the supply curve S and the price level is OP and the employment level is ON. When the aggregate supply is reduced due to any of the factors mentioned above, the supply curve S shifts to the left at S1. The new equilibrium is at E1 where S1 intersects the D curve. Now the price level rises from OP to OP1 and the level of employment declines from ON to ON1.

Measures to Control Stagflation:

We have observed above that it is inflation that leads to stagflation. The US experience shows that if stagflation is controlled either by restrictive or expansionary measures, it will increase. Suppose restrictive demand managed monetary and fiscal measures are adopted, they tend to lower aggregate demand so that the new demand curve D1 cuts the supply curve S1 at point E’ at the old price level OP in Fig 19.

This policy reduces the level of employment further to ON’ and at the same time lowers the price level from OP1 to OP. Thus such a policy tends to increase unemployment by N1N’ and reduces inflation by P1P. Thus it fails to control stagflation. On the other hand, if expansionary demand managed monetary and fiscal policies are adopted, they will raise the aggregate demand so that the new demand curve D2 cuts the supply curve S1 at E2 at the old employment level ON.

This raises employment from ON1 to ON but increases the price level to OP2. Thus such a policy also fails to control stagflation because it generates more inflation combined with higher employment. Economists, therefore, suggest other measures which slow inflation and maintain higher employment.

First, minimum wages should not be raised at all.

Second, tax-basedincome policies should be started. These policies are different for individual and business firms. In the case of individuals, target rates of wage and price inflation are based on some reasonable economic forecast of inflation.

Persons who accept wage increases below the target rates are rewarded with tax credits. Those who insist on wage increases above the target rates are levied a penalty tax. Similar is the case with business firms. Firms which keep wages down to the target rates are rewarded with a reduction in their business income tax. On the other hand, those who permit wage increases above the target rates are charged a penalty tax in addition to business income tax.

Third, there is need to introduce income policies. One of the important planks of the income policies is to link the increase of money wages to productivity increase. Thus the rate of increase of money wages should be limited to the overall rate of productivity increase.

Further, prices should be reduced in those industries having above-average productivity growth. On the other hand, prices should be raised in industries where productivity is increasing less than the national average rate.

Prices should be kept stable in industries where productivity is increasing at the national average rate. But such policies are difficult to implement in the case of an open country. If import prices of food and other consumer products rise, they tend to raise the domestic price level. This makes it difficult for unions to stick to wage agreements.

Fourth, the best policy measure is to reduce personal and business taxes because they tend to reduce labour costs and raise demand for labour. Similarly, sales tax and excise duties should be reduced in order to prevent the price level from rising. To encourage state and local government to reduce state and local sales and excise taxes, the central government should sanction additional grants-in-aid to them.

Thus to combat stagflation, a vast spectrum of policy measures is needed.